Risk Management Tools: Dairy Revenue Protection

Andrew Sandeen, PennState Extension

Dairy Revenue Protection is designed to provide opportunities when high prices can be protected, potentially guaranteeing income above the breakeven for a farm.

Photo: Andrew Sandeen, Penn State Extension

Is the Dairy Revenue Protection program something on your list of things to figure out someday? There is good news for the many producers who have not yet taken their first steps to figure out how to engage with this risk management tool:

there is no deadline for signing up,

the decision is yours whether to dabble with a small amount of milk coverage or commit a sizeable share, and

the federally subsidized premiums aren’t due until after the coverage period is over.

What does DRP do?

Dairy Revenue Protection addresses the risk of unexpected drops in dairy prices. A price can be locked in for a future quarter, establishing a minimum revenue amount without losing any potential on the upside.

Dairy Revenue Protection is completely different than other dairy programs such as Dairy Margin Coverage. It is not designed to provide relief whenever prices or margins are low. Rather, it provides opportunities to find times when high prices can be protected, potentially guaranteeing income above the breakeven for a farm. There might be other times when it is used to minimize damage when there is a threat of significant losses.

Why look at it now?

Every step taken now will prepare you for the time window when prices might be at a level you should take advantage of. The reason to be ready now is that the ideal window of opportunity for your farm may be brief, leaving too little time to learn the ins and outs of a new program. The numbers change almost every weekday. Also, it is beneficial to establish a relationship with your preferred provider and have some of the initial paperwork completed, which can be done without committing to an endorsement.

“The DRP is the best dairy safety net in the world. The only problem is you have to use it. Now is the time to begin planning for 2021. Going forward producers need to take personal responsibility… and if they don’t, they won’t be around.” Professor Marin Bozic – University of Minnesota

What decisions need to be made?

Quarter for coverage – At any one time, sales are open for as many as five quarters. Sales close 15 days before the beginning of a quarter. Distant quarters don’t open for sale until there is adequate market activity.

What to cover – The choices are Class III milk, Class IV milk, or a selected butterfat and protein combination. The choice is yours. The only obligation is that 85% of the covered milk volume or 90% of the components be delivered in order to receive full payments.

How much to cover – Any volume can be selected for an endorsement, with no limit to the number of endorsements within a particular quarter.

Protection factor – This is a factor built into the program for the purpose of increasing coverage on a specific volume of milk, anywhere between 1 and 1.5. A higher factor level will increase coverage (and increase the premium) at the same milk volume.

When to purchase – The market changes daily. Endorsements must be purchased between the market closing and the next opening, meaning the time window on the U.S. East Coast is typically between 4 p.m. and 10 a.m.

Decision #3 – Cover half of the anticipated production for 3Q2020, which is 1 million pounds.

Decision #4 – Go with a protection factor of 1.5 to provide more coverage for the same volume of milk. This still leaves half of the milk uncovered, with opportunity to purchase additional endorsements in the future, should there be other good opportunities.

Decision #5 – Pull the trigger on an endorsement after seeing the Class Ill prices and premiums for January 21. 2020. The Class Ill price is $17.95. allowing the farm to guarantee a revenue price at $17.05 (95% of $17.95) with a premium rate of $0.1264, though everything is multiplied by 1.5 because of the protection factor.

Revenue Guarantee= $255,750

Total Subsidized Premium= $1,896

Result – If the Class Ill price for the third quarter of 2020 turned out to be $16.50, then the farm would receive a payment of $6,354 plus or minus a state or regional yield adjustment factor.

On the graph above, the guaranteed prices represent 95% of the class prices, which is the maximum coverage possible with the DRP program.

A loss mitigation example

On March 25, 2020, the same farm hears advice from a dairy economist to consider loss mitigation coverage for future quarters because of extremely negative market conditions, just in case prices continue to drop and don’t recover well. They wait until that afternoon when prices are released, then quickly contact their DRP insurance broker and purchase an endorsement.

Class Ill & Class IV breakeven price: $16.75 / cwt

Annual production: 8 million pounds

Decision #1 – Purchase an endorsement for the second quarter of 2021.

Decision #2 – Focus on Class IV milk price coverage.

Decision #3 – Cover half of the anticipated production for 2Q2021, which is 1 million pounds.

Decision #4 – Go with a protection factor of 1.0.

Decision #5 – Purchase an endorsement on March 25, even though it is guaranteeing revenue significantly below the breakeven price. The Class IV price is at $15.87, resulting in a revenue guarantee at $15.08 (which happens to be significantly higher than what is available in the days that follow), costing $0.4409 per cwt.

Revenue Guarantee= $150,800

Total Subsidized Premium= $4,409

Result – If the Class IV price for the second quarter of 2021 turned out to be $16.50, then there would be no payment and the $4,409 premium payment would be billed in July 2021, the month following the end of the quarter.

If the Class IV price for the second quarter of 2021 turned out to be S12.00, the net benefit to the farm would be approximately $26,391.

On the graph above, showing the movement of prices for the second quarter of 2021, notice the gaps in the data. These gaps represent the days when class coverage with DRP was not available either because of insufficient trading activity or the release of a significant market report.

Lastly, for anyone looking to take advantage of Dairy Revenue Protection coverage, it is highly recommended to work with an insurance provider who is familiar with the dairy industry and who understands the DRP program well. There are limitations to the changes that can be made between providers, so be comfortable before committing. They should be able to assist in making an educated decision that you are comfortable with to provide some protection against future price drops.

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